Welcome shift in RBI’s outlook

Following the bi-monthly monetary policy review held on June 2, the RBI has not only adjusted the short-term interest rate but also aired its views on macroeconomic policy more generally.

In doing so, the RBI has signalled a perceptible shift by it towards the centre on the two concerns of macroeconomic policy, namely growth and inflation. Not only has its Governor spoken with candour, but he has spoken much sense.

Raghuram Rajan has deviated from the standard text of contemporary central banking which is heavily influenced not just by the discourse on macroeconomics in the United States -- and within the US, by a small yet powerful segment.

Dubbed ‘fresh-water macroeconomics’, given its hold over the minds of economists resident among the great lakes of mid-western America, it renders a view of the economy that is both concise and controversial.

Its central assertion is that when an economy is left to its own devices the level of output tends towards its potential, referred to as the ‘natural level’ of output.

Further, we are told that when the actual level of output is at its potential, there will be no inflationary pressure emanating from within an economy. Such pressure arises only when the actual level of output is maintained above the potential due to intervention.

By this account, inflation reflects a so-called output gap. But why should such an output gap exist at all? It arises when the actual rate of interest is kept below the natural rate of interest, the rate at which investment equals saving.

Why should the actual rate be below the natural rate ever? It is held to derive from the tendency of commercial banks to try expanding credit by cheapening it.

As aggregate demand expands, while the potential output of the economy remains unchanged, a positive output gap emerges and inflation accelerates.

In the language of amateur economists the economy has ‘overheated’. Contractionary policy must now follow to eliminate the output gap.

This view of the economy underpins the argument for inflation targeting, wherein the central bank sets the interest rate to control inflation by affecting the output gap.

While this breathtakingly simple story has captured the minds of many practitioners, including our own RBI itself, it is not very helpful as a guide to policy.

According to the theory it is not the level of the rate of interest that matters for the output gap but the extent of its deviation from the natural rate of interest. Further, this natural rate is not treated as fixed but recognised as subject to change.

This complicates matters for the monetary authority, which is given the task of setting the rate of interest. There is no longer a formula according to which it can go about its business. Champions of inflation targeting tend to keep this crucial issue under wraps.

Having conveyed the image of being a hawk on inflation, the RBI Governor appears to have undergone a change of mind. In the press conference following the release of the last bi-monthly monetary policy statement, Rajan spoke of the economy experiencing a deficiency of demand. This suggests a softening of the stance that inflation alone should guide policy.

In fresh-water macroeconomics demand deficiency is ruled out of court as it is simply assumed that the economy will naturally find its potential, without any handholding so to speak. The Governor had alluded to a demand deficiency reflected by the existence of unutilised capacity and slow credit offtake.

He had then proceeded to speak of the importance of public investment at this juncture for raising the rate of growth. It is correct to say that when private investment is skittish public investment can buoy up aggregate demand.

This possibility is denied by conservatives who argue that greater public investment only succeeds in crowding out private investment as the pool of savings needed to finance investment is fixed.

But the pool of savings actually expands along with income when aggregate demand increases in an economy with unemployed resources. Public investment can in principle expand output over two rounds, first directly and secondly indirectly by raising private investment as the market expands.

This elementary principle of macroeconomics bears a message for Team NaMo. The private sector is unlikely to respond to homilies, only to profit opportunities.

Public investment can create these opportunities. The Governor clearly sees the potential of public investment when he spoke of its ‘crowding in’ effect.

Central bankers in the Anglo-American mould usually give little importance to the government’s actions partly with a view to exaggerate their own. This approach has been strenuously pushed via academic work in the US. Rajan appears to be saying the opposite.

He seems to be saying that the central government’s macroeconomic policy actually matters for growth. Most unusually for him, though, he seems to be saying the same thing vis-à-vis inflation!

He has always held that fiscal consolidation matters for inflation, but has now gone further to state that there is a direct role for the central government in inflation control via the management of food stocks. Towards this end he has spoken of the need to extend price support to a wider range of crops than just the cereals, but in the same breath – and somewhat confusingly – spoken of the need to temper support price increases that are inflationary.

One thing is clear. The drift of his argument is that the supply-side matters for inflation. This is a move away from the position taken in fresh-water macroeconomics that inflation is a demand-side phenomenon requiring the curtailing of aggregate demand.

By opening up a role for government in the management of inflation, Rajan seems to be weakening the case for inflation targeting. Within the ‘modern monetary policy’ framework that the Finance Minister had spoken of in his last budget speech, the Ministry sets the target that the RBI is mandated to pursue.

But if the government were to set a wide range of agricultural prices a conflict of interest opens up, as it would be setting both the target and the price. There would not be much left for the Bank to do as far as inflation is concerned!

So, if the Governor’s recent statement reflects a change of thinking at the RBI it seems to be that growth needs guidance and inflation cannot be controlled by monetary policy alone. This is exactly as it should be.

Since 1991, especially under UPA II, there has been an excessive concern with adopting institutional architectures found to the west of the Suez, no matter what the economic outcomes. Rajan has not been immune to such a mindset, his enthusiasm for inflation targeting being the main case in point.

A slight but perceptible shift away from the dogma is now apparent. This is entirely to be welcomed as it reflects a willingness by this country’s policy establishment to learn from history.

The writer is professor of economics at Ashoka University